In tax planning, it always has been important to determine whether an activity qualifies as a “trade or business.” There are a number of consequences. An important consequence is being able to deduct “ordinary and necessary” business expenses under Sec. 162. Others are the applicability of the 3.8% net investment income tax, hobby loss rules under Sec. 183, and deductions for business bad debts under Sec. 166.1
With respect to qualification as a “trade or business,” the stakes have been raised. Under the Tax Cuts and Jobs Act (“TCJA”), taxpayers are no longer able to take certain miscellaneous itemized deductions. Therefore, if your activity is not a “trade or business,” the deduction now will be lost completely. Further, the TCJA included a new Sec. 199A providing the ability for income from sole proprietorships and pass-through entities to qualify for a 20% deduction (subject to certain limitations). However, this 20% deduction only applies to income from a “trade or business.”2 Therefore, under the TCJA, failure of an activity to qualify as a trade or business causes the compound issue of both: (1) loss of the ability to deduct expenses; and (2) loss of the ability to take a 20% deduction with respect to the activity’s income.
Definition of a “Trade or Business”
Nowhere in the Internal Revenue Code or in the regulations is there a definition of the term “trade or business.” However, as indicated above, that distinction has been important well before the TCJA. Over time, a body of law has developed determining what constitutes a “trade or business for tax purposes.”
As a general matter, to constitute a trade or business, “the taxpayer must be involved in the activity with continuity and regularity” and “the taxpayer’s primary purpose for engaging in the activity must be for income or profit.” 3 A sporadic activity, a hobby, or an amusement diversion does not qualify.”4 The determination of whether an activity constitutes a trade or business is determined by the specific facts of each individual case.5It is clear that managing one’s own investments, no matter how extensive, is not a trade or business. 6 The courts will look to objective facts, not the taxpayer’s subjective intent, to render this determination. 7 Merely researching or investigating a potential business is not a trade or business. 8
Based on this, the two factors a taxpayer needs to substantiate in order for his or her activity to qualify as a trade or business are:
- participation in the activity with continuity and regularity; and
- profit motive.
Failure to satisfy either of these two requirements will cause the activity not to qualify as a trade or business. As indicated in this article, qualification as a trade or business can have significant tax consequences.
Taxpayers bear the burden of proof to show a profit motive. 9 From a review of case law, there are a number of factors that will be considered to determine whether the taxpayer has carried the burden of proving an activity is undertaken with continuity and regularity and with a profit motive. Some of those factors are as follows:
- maintenance of adequate books and records for the activity, including whether commingled with other items of the taxpayer. 10
- low profits relative to profits from other activities; 11
- time devoted to other activities or professions; 12
- whether services provided to third parties or, rather, primarily to friends and family; and 13
- level of involvement in the activity and active steps taken in the activity to generate current profits. 14
Of course, there are any number of other factors which may be relevant since qualification is based on the facts of each specific case. In determining whether a profit motive is present, factors in the Sec. 183 regulations have historically been consulted. 15 Those factors are:
- manner in which the taxpayer carries on the activity (i.e. is it carried on in a “business-like manner?”);
- expertise of the taxpayer and his advisors;
- time and effort expended by the taxpayer in carrying on the activity, especially where there are no “substantial personal or recreational aspects;”
- expectation that assets used in the activity may appreciate in value;
- success of the taxpayer in carrying on other similar or dissimilar activities;
- taxpayer’s history of income or losses with respect to the activity, which can be strong indicator of a profit motive if there is a series of years in which net income was realized;
- the amount of occasional profits, if any, which are earned, especially in relation to the amount of losses incurred;
- financial status of the taxpayer; and
- elements of personal pleasure or recreation. 16
As can be seen, there is some overlap in the factors under the Sec. 183 regulations and the factors courts have analyzed otherwise.
It is clear that merely forming a legal entity will be insufficient. 17 While some taxpayers believe that simply forming a legal entity and filing a tax return on behalf of an entity is sufficient to case a trade or business to result, more is required.
Certain Specific Activities
With respect to many activities, it is a simple determination as to whether a trade or business as defined above exists. However, with others, the analysis is not always so clear. Two particular areas of note where this can be seen are: (1) the ownership of rental real estate; and (2) management of investments. Of course, there may be many other activities where this issue is important, but after the TCJA, it appears that these two areas may be of interest to a substantial number of taxpayers.
Rental Real Estate
Over the years, there has been a lot of case law surrounding whether ownership and leasing of rental real estate can constitute a trade or business. Probably the most important case in this area is the Curphey case. 18 In that case, a dermatologist owned six units which he managed by himself from a home office. He personally managed the properties, sought new tenants, furnished the properties, cleaned the properties, and prepared them for new tenants. The Tax Court noted the IRS had conceded that management of a taxpayer’s real estate for the production of income constituted a trade or business. 19 The Curphey court noted that after the Higgins case the Tax Court had held “that rental of even a single piece of real property for the production of income constitutes a trade or business.” 20 Based on these facts, the Tax Court held that the taxpayer’s activities constituted a trade or business.
A number of cases have found trade or business status when only one parcel is owned. 21 Notwithstanding Curphey and similar case law, the Tax Court has noted that management of a single piece of real property for the production of income does not automatically qualify as a trade or business. 22 The requirements for a trade or business still must be satisfied. An example that fails to qualify as a trade or business may be the case of a triple-net lease arrangement where the tenant pays all taxes, pays all insurance, and maintains the property. 23 Based on this case law history, it appears to be somewhat easy to satisfy the requirements of a trade or business with respect to rental real estate. However, care should be taken to at least be sure the taxpayer is actively engaged, regularly and continually, with respect to at least some aspects of property management. Therefore, triple-net leases may need to be reviewed and modified.
As cited above, management of one’s own investments is not a trade or business no matter how extensive. 24 Likewise, an important factor in determining whether an activity constitutes a trade or business status is whether third parties are involved or, alternatively, whether the activity is only for friends and family. 25 As such, when an individual is managing his or her own investments, even when acting as an investment manager for friends and family as well, it is unlikely the requirements to constitute a trade or business has been satisfied.
The primary exception to disqualification is when the taxpayer qualifies as a trader. In determining whether a taxpayer qualifies as a trader, the courts will review certain factors: 26
- the taxpayer’s investment intent;
- the nature of the income to be derived from the activity; and
- the frequency, extent, and regularity of the taxpayer’s securities transactions.
The primary distinction in a trader vs. investor is that a trader buys and sells securities frequently to catch swings in the daily market whereas an investor purchases securities to be held for capital appreciation and income. 27 If an individual qualifies as a trader, then the requirements for a trade or business should be met.
A relatively new opinion which addresses whether the activities of a taxpayer in managing his family’s investments can constitute a trade or business is Lender Management. 28 In that case, a partnership took Sec. 162 deductions based on activities undertaken in managing a family’s investments. Solely based on its facts, the Tax Court held that the partnership’s role in managing a family’s investments constituted a trade or business. Some of the more relevant facts were:
- the partnership had full time employees receiving substantial compensation that engaged in substantial activities, reviewing approximately 150 private equity and hedge fund proposals every year;
- the partnership’s CFO worked approximately 50 hours per week;
- The partnership provided investment advisory and financial planning services for a variety of clients;
- the partnership’s services were comparable to those provided by hedge fund managers, which included annual meetings with its investors and preparing computer models of investments;
- the partnership received a carried interest as compensation, similar to what would be offered to third-party managers;
- although the partnership managed a family’s funds, the family was geographically diverse, many did not know each other, and some conflicted with others; and
- investments made were driven by the individual needs of the family-member investors rather than the needs of the partnership. Also, the investors were able to withdraw investments if dissatisfied.
Based on the Lender Management case, the consolidated management of investments for family may constitute a trade or business. However, in order to qualify, the facts must substantiate the underlying arrangements in a way which rises to the level of a true trade or business rather than mere passive investment of a family’s wealth. Further, this case illustrates that an investment manager receiving a carried interest may still be involved in a trade or business. Both of these outcomes can be critical for taxpayers.
While it always has been important, after the enactment of the TCJA, it has become much more important that activities qualify as a trade or business. Not qualifying can be a whipsaw for the taxpayer, losing both the ability to deduct losses and expenses as well as the ability to take advantage of the 20% deduction for qualified business income under Sec. 199A. As described above, the analysis is fact intensive and has resulted in significant litigation over the years.
Taxpayers and their advisors would be well advised to structure their affairs to qualify as a trade or business. When structuring arrangements, taxpayers are faced with a number of choices. Given the importance of qualifying as a trade or business, taxpayers should review the relevant factors and, to the extent the facts and circumstances allow, structure their affairs to satisfy the relevant requirements. The difference in how a taxpayer’s activities are structured and managed may cause a significant difference in the tax treatment of such activities.
- It is important to note that the test for qualifying as a “trade or business” is a different analysis than for material participation under Sec. 469, the primary consideration under the net investment income tax.
- Prop. Treas. Reg. § 1.199A-1(b)(13).
- Comm. v. Groetzinger, 480 U.S. 23, 35 (1987).
- Higgins v. Comm., 312 U.S. 212, 217 (1941).
- Id.; Whipple v. Comm., 373 U.S. 193 (1963); Beals, T.C. Memo 1987-171 (1987).
- Litwin v. U.S., 983 F.2d 997, 1000 (10th Cir. 1993).
- Baldwin, Lucian T. III, T.C. Memo 1971-326 (1971).
- Wolf v. Comm., 4 F.3d 709, 713 (9th Cir. 1993).
- See Ypsilantis, John J., T.C. Memo 1992-644 (1992); Beauchamp, Kim, T.C. Memo 1997-393 (1997); Beeton, William, T.C. Memo 1987-427 (1987); Streck v. Comm., 187 F.3d 638 (6th Cir. 1997); Doxtator, Allen, T.C. Memo 2005-113 (2005);
- Beauchamp, Kim, T.C. Memo 1997-393 (1997).
- Id.; Pouemi, Valery Choutouo, T.C. Memo 2015-131 (2015); Beeton, William, T.C. Memo 1987-427 (1987); Fitch, Grant, T.C. Memo 1960-268 (1960).
- Thomason, Harry, 1997-480 (1997); Heinbockel, Edmond Audrey, T.C. Memo 2013-125 (2013); Pouemi, Valery Choutouo, T.C. Memo 2015-131 (2015). But see Lender Management LLC, T.C. Memo 2017-246 (2017); Vianello, Marc, T.C. Memo 2010-17 (2010); Samadi, Homayoun, T.C. Summary Opinion 2018-27 (2018).
- Keenan, Robert, T.C. Memo 1989-300 (1989); Shea, James, T.C. Memo 2000-179 (2000); Heim, Joel, T.C. Memo 1978-137 (1978); Perkal, Stuart, T.C. Memo 1983-489 (1983); Beard, Hugh Jr., T.C. Memo 1995-41 (1995).
- Ypsilantis, John, T.C. Memo 1992-644 (1992); Householder, Scott, T.C. Memo 2018-136 (2018).
- Treas. Reg. § 183-2(b).
- See Brown, Phillip, T.C. Memo 2017-18 (2017); Garcia, John, T.C. Summary Opinion 2018-38 (2018).
- Curphey, Edward, 73 T.C. 766 (1980).
- See Higgins v. Comm., 312 U.S. 212 (1941).
- Citing Fegan v. Comm., 71 T.C. 791, 814 (1979); Elek v. Comm., 30 T.C. 731 (1958); Lagreide v. Comm., 23 T.C. 508 (1954); Noble v. Comm., 7 T.C. 960 (1946); Hazard v. Comm., 7 T.C. 372 (1946).
- See Hazard v. Comm., 7 T.C. 374 (1946); Noble v. Comm., 7 T.C. 960 (1946); Fegan v. Comm., 71 T.C. 791 (1979). See also FSA 200120036.
- Anderson, Byron, T.C. Memo 1982-576 (1982).
- See Neill, 46 BTA 197 (1942). Also see Balsamo, T.C. Memo 1987-477 (1987) where the taxpayer sold a parcel of inherited property, already under lease, to the tenant shortly after receiving the property.
- See supra. note 6.
- See supra. note 13.
- Mayer, Fredrick, T.C. Memo 1994-209 (1994); Moller, Joseph v. U.S., 721 F2d 810 (Fed. Cir. 1983); Chen, Frank, T.C. Memo 2004-132 (2004); Yaeger, Louis Est v. Comm., 889 F.2d 29 (2nd Cir. 1989).
- Chjanh Hsiao Liang, 23 T.C. 1040 (1955); King, Marlowe, 89 T.C. 442 (1987); and Chen, Frank T.C. Memo 2004-132 (2004).
- Lender Management LLC, T.C. Memo 2017-246 (2017).